My first book purchased on Kindle.Nobel Laureate George Ackerlof and Robert Shiller are pretty high-powered economists. And their book follows along the current economic research along behavioral economics.
A quick recap of what we know. In the standard neo-classical economic framework, the world is filled with homo economicus. This rational human being optimizes all economic decisions, does not let emotion get in the way of living a fully optimized life, and resembles Mr. Spock in a fashion.
Now we know that human beings in real life nowhere resemble this rational human being; we forget to pay our bills on time, we spend on things that have negative expected return. But economists have long assumed that on the aggregate these ticks cancel each other out and that the model of the rational human being is a pretty good description of the world that we live in. Or as my grad professor puts it: "For every idiot, there exists an equal and opposite idiot."
Behavioral economics, to our great consternation, shows that this is completely false.
Sociologists might scoff at us idiot savant and say "no shit, Sherlock", but it would be wrong, I think, to simply dismiss this as economist mathematically prove that human being are, well, human beings. Insights that we are on the whole irrationally risk averse, that we consistently ignore things such as inflation (I'll get back to this), and have very malleable preferences. The last discovery might also earn us a "no shit, Sherlock" from the Madison Avenue crowd, but that poses an existential conundrum for an academic discipline that for the most part take consumer preferences as an exogenous factor.
This also tilts the economics towards what should the optimal political organization be. For example, a fundamental driving assumption for libertarians is that individuals make better decisions for themselves. And here what research says is that in a lot of cases, this is consistently not true.
The one point Ackerlof and Shiller brought up that was pretty though provoking is the the idea of "inflation illusion". We know that inflation runs about 2% per annum (ignoring the current recession, which has generated some pretty strong deflationary pressures), and yet people consistently treat inflation as being nonexistent. This is a very different observation that the Chicago school rational expectations claim, which says that individuals account for inflation.
Well, it turns out that there is a huge policy implication with regards to this question. Because as it turns out, the Phillips curve, the positive correlation between unemployment rate and inflation, depends crucially on who's right. If Ackerlof and Shiller is right, pushing inflation down to zero will throw millions of Americans out of work. If Friedman and the Chicago school is right, then you can fight inflation without causing any unemployment.
Literally millions of jobs depends on this. And that makes Animal Spirit and the current thrust of research in economics rather topical.
3 comments:
Between Shiller and Friedman I'd always bet on Shiller being right, no matter the issue under discussion.
Let's bring this a step further. If people indeed treat inflation as nonexistent, we would expect huge inflationary pressures to build over time. For example, individuals, pension funds and even countries may stockpile huge amounts of US dollars, e.g. in the form of treasury bills. Large government programs, such as Social Security, may also invest surpluses in treasury bills with the expectation of redeeming them at a later time when shortfalls are expected.
One day one of these large buyers will try to redeem their dollars for real, hard assets, either by choice or because of imminent necessity. If one of these large buyers stops buying treasuries and starts selling them, wouldn't this instantly cause chaos in the treasury markets? Wouldn't all participants try to sell their own treasuries at the same time hoping to get out before the dollar is in freefall?
Such a collapse would be a calamity of monumental proportions for the US economy, one that the Fed and the US government would try to avoid at all cost. The best option would be to find another buyer who would be willing to replace the original buyer. This appears to be a classical Ponzi scheme where early investors are compensated with money from late investors. The only way to continue is to keep finding new investors. Eventually, there will be no more investors to be found. The buyer of last resort will be the Fed. The Fed doesn't need to have the money, they can just print it. When this happens we will understand what inflation really is.
So, unlike people who treat inflation as nonexistent I am trying to get as large a loan as I can afford now to buy a house. I expect that 10 to 15 years from now my mortgage payment will be about the same as the payment on a new car.
Shiller's argument is more nuanced than my dime version.
His argument is not that there is no rational expectation, but it doesn't kick in until inflation is sufficiently high. So when inflation is at 10%, rational expectation, at 2%, nothing.
My theory is that at 2%, your life time earning cycle more than swamps that out. Why bother with that 2% when you just got moved up the chain?
Inflation affects mostly your savings (if you have any) or large loans (e.g. your mortgage). It does not have significant impact on your earnings since most companies give their employees an annual raise to compensate for it. If inflation is indeed at 2% you can more than offset it by buying government bonds. My personal expectation is that inflation (of the US dollar) will be much higher over the next 30 years.
But I may be wrong. I have been wrong about many things.
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